Question

Micro Spinoffs, Inc., issued 10-year debt a year ago at par value with a coupon rate of 8%, paid annually. Today, the debt is selling at $1,160. If the firm’s tax bracket is 35%, what is its after-tax cost of debt? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

After-tax cost of debt

%

Answer 1

The after-tax cost of debt

• The Yield to maturity (YTM) of the Bond is the discount rate at which the Bond’s price equals to the present value of the coupon payments plus the present value of the Face Value/Par Value
• The Yield to maturity of (YTM) of the Bond is the estimated annual rate of return expected by the bondholders for the bond assuming that the they hold the Bonds until it’s maturity period/date.
• The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Par Value/Face Value of the Bond [$1,000]	FV	1,000
Coupon Amount [$1,000 x 8.00%]	PMT	80
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [10 Years – 1 Year]	N	9
Bond Price/Current Market Price of the Bond [-$1,160]	PV	-1,160

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the annual yield to maturity on the bond (1/Y) = 5.68%.

The annual Yield to Maturity of the Bond = 5.68%.

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Annual Yield to maturity on the bond x (1 – Tax Rate)

= 5.68% x (1 – 0.35)

= 5.68% x 0.65

= 3.69%

“Hence, the after-tax cost of debt will be 3.69%”